We're back with part 2 of our Q&A on 409A valuations. If you haven't read it, check out part 1 here. 409A valuations come into play once founders and management start thinking about their first hires, so understanding them early is important. We'll have more posts on the topic, which will deal with finer points, but let's finish up the Q&A with our friend and valuation expert, Bo Brustkern.

Bo is Managing Director and founder of Arcstone Partners,[1] a business valuation firm, and he has over 17 years of experience as an investment and valuation professional.He has been quoted in a variety of publications, including The New York Times and Financial Times.

EZ: What are the safe harbors for 409A valuation and why do they matter?

The reason the 409A safe harbor is so important is that it shifts the burden of proof to the IRS, meaning the company’s valuation is presumed to be correct unless proven grossly unreasonable.

There are several safe harbor methods outlined in the 409A code, including:

1)the illiquid start-up,

2)binding formula, and

3)independent appraisal approaches.

In order for any of the safe harbors to comply, the method must incorporate evaluation of a number of factors, including: (i) the value of tangible and intangible assets of the company, (ii) the present value of future cash flows, (iii) the public trading price or private sale price of comparable companies, (iv) control premiums and discounts for lack of marketability, (v) whether the method is used for other purposes, and (v) whether all available information is taken into account in determining value. Simply put, section 409A allows a company to find a safe harbor within the Code by obtaining an appraisal of company stock by an established firm practiced in the art of business valuation.

Pro tip: so guess which reports go to the top of the IRS’ prosecution stack? Internally produced valuations, and those conducted by black-box “fully-automated” software-based valuations, which do not fit the safe harbor test.

EZ: Can a company do its own 409A valuation? What are the requirements?

A company is allowed to do its 409A valuation in-house (although it’s usually not a good idea). The 409A regulations allow “persons with significant knowledge and experience or training in performing similar valuations” to conduct a valuation for 409A purposes and stay within the safe harbors allowed by 409A. The IRS takes care to define “significant” as having at least five years of expertise in “performing similar valuations.” Clearly, a VC or PE investor, or board member, or CFO “values” companies all the time. However, very rarely have we known any such person that actually has so much expertise performing similar valuations, for 409A valuations are very particular and nuanced in their execution.

Note the following observation from the Herbert vs. Kohler (2006) tax court case, per the industry rag Business Valuation Review:

“The taxpayer prevailed on this argument because their witnesses were highly qualified and they followed generally accepted valuation approaches. The court noted that the experts were certified appraisers. The court was impressed by the valuation methodologies used and the conclusions of the taxpayer's appraisers. In addition, the court noted the appraisers' compliance with USPAP [a core valuation standard].”

EZ: What are the pitfalls of issuing options whose exercise price is deemed to be lower than the FMV of the underlying stock?

Lower: major problem. The IRS and others can essentially tax and penalize the employee in major ways, wiping out all the employee's winnings.

Higher: not a problem.

EZ: How much does a 409A valuation from a third party valuation expert cost?

For a seed-stage startup with a $1 million convertible note financing, expect to pay between $3500 and $4500 from firm of reasonable quality and reputation, if they specialize in early stage entities. For a late-stage entity pre-IPO, valuations could run you $8000 to $15000 per valuation, with valuations occurring every 3 to 4 months. Just like legal and audit fees, your budget for financial valuation compliance will expand as your company does. Prepare to spend $4000 in year one and $40000 in year five for valuation compliance.

EZ: Any other issues management should think about relating to stock option valuations?

Yes indeed. We have seen an increasing amount of litigation (e.g., employee vs. company) in the very recent past, leading us to believe that 409A valuations are being used for a variety of purposes beyond just IRS and SEC compliance, and they are setting the stage for fights over valuation after companies succeed or fail. The old “hey you screwed me! See here on the 409A where it says we were worth [x]?!?” To avoid this dispute, or at least be better prepared when it occurs, company management is wise to procure contemporaneous valuations of high quality throughout a company’s life. This alone can make a huge difference for company management as they inevitably face these difficult situations.

Founders and management should familiarize themselves with 409A valuations early in the company’s life. Section 409A of the Internal Revenue Code will come into play once you start to think about hiring. We’re here to help and we’ve brought in the big guns. We’ve enlisted friend of EquityZen and business valuation guru Bo Brustkern to answer fundamental questions about 409A valuations. This is the first in a series of blog posts on 409A valuations, and future posts will address more nuanced topics.

Bo is Managing Director and founder of Arcstone Partners,[1] a business valuation firm, and he has over 17 years of experience as an investment and valuation professional. He has been quoted in a variety of publications, including The New York Times and Financial Times. The format is Q&A—let’s get right into it…

Under section 409A, stock options that have an exercise price less than the Fair Market Value (FMV) of the underlying stock as of the grant date could result in adverse tax consequences for the option recipient. The gain is subject to taxation at the time of option vesting rather than the date of exercise, with potentially devastating penalties and interest charges. In short, the consequences for noncompliance, which affect the individual who holds the options and not the issuing company, are significant.

To avoid these consequences, management teams can issue options with an exercise price at FMV, and section 409A provides clear approaches on how to develop compliant policies. These safe harbors shift the burden of proof of noncompliance to the IRS. That simply means that if a company employs a safe harbor method to value the price of its stock options, the IRS must show that the company was grossly unreasonable in calculating the FMV.

EZ: What are the key inputs in determining a 409A valuation?

It depends on the stage of the company and complexity of transactions, but factors considered include financial statements (historical and projections), capital structure/rights and preference of securities, market/industry outlook, business model/outlook, public comparable companies/comparable transactions, and expectation/probability of timing for exit and failure.

EZ: At what point is a company required to do a 409A valuation?

A company must do its first 409A valuation prior to the first issuance of stock options.

EZ: How often must a company do a 409A valuation?

A company must do a 409A valuation every 12 months at a minimum, and any time a major change has occurred that either reduces risk or materially changes forecasts. Practically speaking, this means after a new round of financing is raised), or after any transaction involving the company’s assets (e.g., the company has acquired another, or divested itself of material assets).

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Revenue ruling 59-60 goes on to say that:

Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.

There is also Fair Value (FV), or the GAAP valuation standard, which is defined by the Financial Accounting Standards Board (FASB). For 409A purposes, the FMV is the standard of relevance; but most 409A valuation reports these days comply with both FMV and FV standards.

For high growth companies, one of the most efficient and effective ways to align interests among stakeholders, and to allocate wealth among those who help to create it, is through the issuance of stock, stock options and restricted stock units. This holds true for companies at the very earliest stages of formation all the way to large, publicly traded entities whose prospects for growth continue.

Stock options are most valuable when the underlying stock can be readily exchanged in a wellfunctioning, liquid marketplace. Stock options for public market companies are the premiere example of this. For example, those employees who received stock options of publicly traded Apple, Inc. in 2003 at a strike price of $9.00 per share, and whose awards vested during the following years, have enjoyed spectacular returns on their investment of time as they have collectively built AAPL to approximately $400 per share as of this writing. This represents a $350 billion market cap, making AAPL among the most valuable companies on the planet.1 For the hypothetical employee, this represents an instantaneous gain of $391 per share, or 43.5 times the strike price of the stock in only eight years.

1) I use examples such as Apple because publicly traded companies on the Nasdaq Global Market and the New York Stock Exchange are rich in data transparency and valuations are trustworthy due to robust market dynamics. However, this paper will be focused on private companies, where valuation is uncertain in the absence of a public market.
2) The author is affiliated with Arcstone Valuation, a nationally recognized business valuation firm, and Arcstone Equity Research, an independent investment research firm.

Calculating damages in the litigation context is a specialty within business valuation, which is really to say it’s a niche within a niche. While there is much to be said about getting a solid business valuation practitioner to assist you in determining damages, it gets you nowhere if they do not adhere to the Federal Rules of Civil Procedure, or if their conclusions are thrown out due to a successful Daubert challenge.

Both the business appraiser and the legal counsel must keep a number of key factors in mind when engaging in damage calculations. Listed below are ten such factors to consider, among many.

1.Expert witness reports fall under the Federal Rules of Civil Procedure 26(a)2(b). Make certain your damages expert is familiar with the procedures therein. A strict interpretation of 26(a)2(b) limits evidence introduced in court to that which is actually written or displayed in the report. That means The report must be court-ready and contain all the content on which you and your expert plan to rely to establish (or refute) damages.

2.The financial expert will have an extensive information request. It is in your best interests to fulfill it completely. In a perfect world, all of the data requested can be a) found and b) delivered on a timely basis. Practically speaking, any lists you receive should be prioritized according to importance. Establishing damages will be difficult, if not impossible, if that essential information is unavailable.

3.Make depositions and interrogatories available to the expert. They provide invaluable information about the case. The more your financial expert knows and understands about the situation, the more likely he or she will develop a refined understanding of damages. The result will be a more robust opinion and a more thorough and defensible report.

4.The expert will know that a choice must be made between using an ex ante and ex post approach to lost profits. While some notable professionals choose between these two separate camps, the best approach depends on the facts and circumstances of the particular case. Make sure you discuss the reasonableness of each approach, and allow the appraiser to make an informed decision.

5.The financial expert will know that damage calculations must be valued on a pre-tax basis. Your expert will also understand the role of pre-judgment interest, and how to apply discounts properly when using ex post and ex ante approaches. If you – as counsel, plaintiff or defendant – are concerned about statutory interest rates, discount rates, or taxation issues, discuss them with your appraiser.

6.Daubert challenges are real, and really unpredictable. Expert testimony must be based on methods that 1) are peer reviewed, 2) can be tested, 3) have known error rates, and 4) are generally accepted by practitioners in the realm. McClain vs. Metabolife offers a good discussion of Daubert. A note for our friends in California: you are in a Frye state, which simplifies the challenge, but only slightly, to a single “generally accepted” test. A note for appraisers in general: even the most respected experts in the field of business appraisal have lost Daubert challenges. Don’t underestimate the possibility of your report being thrown out.

7. When selecting a financial expert, competence is critical; however, you also want the ability to communicate confidently. How will the expert appear to the judge or jury? How will he or she contribute to (or detract from) his or her position in deposition, or in direct- or cross-examination? Will the bench or jury enjoy and learn from his or her presence and testimony?

8. Said differently, avoid the jackass. Pardon the expression. First off, life’s too short to work with a professional of such description. More to the point, the judge and jury expect to see expertise confidently displayed and effectively communicated. Just like you, they want nothing to do with the jackass. Because, after all, life’s too short.

9. Do not attempt to direct the appraiser, appraisal or result. Establish and maintain integrity in the process, while the expert arrives at his or her own conclusions. To do otherwise only weakens your case, and possibly harms your relationship with the appraiser. While you may be the advocate for your client, do your best to protect your appraiser from subjectivity or bias. An appraiser is an advocate for the truth, as he or she sees it, and is retained to assist the court in calculating (or refuting) alleged damages. It is dangerous, and possibly self-defeating, to confuse the role of the appraiser with advocacy.

10. One for the BV pro: your purpose is to help the judge and jury. Jury trials are often complex, confusing and daunting for the jury. Help them. The jury understands that this is an adversarial “truth contest,” and they desperately want to find someone they trust. They crave the scientific method; they want a witness for the truth. However, your work does not speak for itself. The truth will not simply appear on its own: You must “reveal” it to the court. You must persuade the judge and/or jury of your position. Do great work. Follow the rules flawlessly. Then stand by your work, speak clearly and confidently, and you will do well by the jury and the judge.